Forty and Fifty Year Mortgages

For a while there, the forty year mortgage had started to make a comeback, and a few lenders started introducing the fifty year mortgage. The reason, straight from the horse's mouth, the lender's representatives, is lowered payments. In an uncertain and unstable market, investors are nervous about interest only financing, and so the lenders are tightening up on the standards of who is able to qualify for that, while looking for another way to compete on the basis of lower payments. Any fig leaf to be getting their premium and avoid competing upon real price. One way that they do this is the Option ARM, or negative amortization loan. However, to anyone who does even a minimal amount of investigation those loans are like cutting your own throat. A lot of people will still sign up for them, but after Business Week did a feature calling them "Nightmare mortgages" more and more people finally started picking up on the tremendous downsides to those loans (and they were finally all but banned, too late to do any good), but if they still want too much house and they've got to be able to qualify for, and make, the payment, they need an alternative. That is the forty and now the fifty year loan.

Note that nobody does forty year fixed rate mortgages, let alone fifty. They do two and three year fixed rate loans, called the 2/38 and 3/37. Some lenders will also do a loan that amortizes over forty years, but the remaining balance is due in thirty years. This so-called 40/30 balloon has a lot in common with a thirty year fixed rate loan - including the fact that almost nobody goes more than five years without refinancing, so that the thirty year balloon should be no big deal. All of the preceding forty year loans are sub-prime loans, by the way, with prepayment penalties and higher rates than A paper. A Paper lenders doing the forty year loan are few and far between. People get longer durations from sub-prime lenders; A paper competes for the best borrowers - the ones who can really afford their loans - on rate/cost trade-off and underwriting standards. For those lenders doing the fifty year loan, it is pretty much the same story. The fifty year amortization due in thirty, the 2/48 and the the 3/47.

Because the lender is risking their money for a longer time, and with less amortization and therefore more risk, most of the lenders - particularly the ones looking to compete on rate that you would prefer to do business with - charge a slightly higher rate for forty year loans than thirty, and a little higher still for a fifty. The difference is not huge, but it is there. Where a 2/28 might be at 7%, the corresponding 2/38 might be at 7.125, and the 2/48 at 7.25 for the same cost. Sometimes they'll say that the difference is as small as a quarter point of cost for the forty year amortization as opposed to the thirty - but that's an eighth of a percent on the rate, at subprime's usual 1 point equals half a percent trade-off.

In my opinion, these longer amortization loans are mostly a marketing gimmick to lower the payment - slightly - for those who do not qualify for interest only under lender's guidelines. The forty year amortization started making a comeback early in 2005, most as the 2/38, and the fifty year about March of 2006.

My initial perception was that refusing interest only to these borrowers is a figleaf tossed to nervous mortgage investors, and this has been borne out by subsequent events. It's not like fifty year amortization is really going to make a difference, as opposed to interest only, from the point of view of remaining principal. If a 100% loan gets foreclosed any time in the first five years, or if property values decline further, the difference is basically insignificant. Let's do some math.

Assume a $200,000 loan on a $250,000 purchase in California, just so I can do it in one loan without worrying about PMI.

Unlike everyone else who has written on longer amortizing loans, I'm not going to obsess about "interest paid over the life of the loan," although if you keep them that observation is true. But that's almost irrelevant. These borrowers are going to refinance in a few years anyway, same as everyone else. That's just the way things are. But let's do look at the difference between interest paid in the first two years, the fixed period for most of these at the end of which people will refinance.

So under these conditions, the 40 year loan only saves $1668.96 in payments over the first two years, and the fifty $2131.92. So if we subtract these numbers off the deficit in the above table, we are left that the forty year loan costs us $1299.30 in net deficit as opposed to the thirty, and the fifty year loan costs us $2434.17 net of all savings. This on top of the fact that it really doesn't make that much difference in the income we need to qualify for the loan (which in my example is limited to cost of housing with no other payments). Just paying off a credit card that takes $100 payments per month will do more to help you qualify.

These numbers get worse, not better, in the bigger loans that the lenders are using them to justify. Let's assume a $400,000 loan on a $500,000 property instead:

Considering that over two years, the forty year payment saves $3339.92 in payments, it's still down by $2599.38 as opposed to the thirty year amortization, and the fifty is down by $4869.83 in just two years - never mind what happens if you have to do it again in two years, and once again, paying off a credit card probably will do more to help someone qualify full documentation.

I don't see anything particularly wrong with forty and fifty year mortgages, although a thirty year loan is better while making very little difference on the payments, I can see some benefits for those who lie in this income range. But pardon my lack of enthusiasm for something that makes very little difference to whether someone qualifies for the loan, while costing them far more than they save in terms of payments, even over the short term and disregarding the effects if the people do not refinance. Far better to just persuade someone not to buy quite so much house in the first place, even if it means you get less of a commission. But then if most real estate agents sold property on the basis of what people could afford rather than it's beautiful and they want it and therefore it's an easy sale and now let's figure out a way to get them the property even if they can't afford it, the southern California real estate market would not have been in the state it has been in these past several years.

Caveat Emptor

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